Demystifying Valuation: A Comprehensive Guide to the Discounted Cash Flow (DCF) Approach

13th edition

Introduction

This edition delves into considerations for valuing companies, including handling subsidiary valuations, surplus funds, and adjusting discount rates for marketable securities. These elements are crucial in refining the valuation process, ensuring that all aspects of a firm’s value are comprehensively and accurately captured.

What aspects of the discounted cash flow (DCF) valuation method remain to be discussed?

Thus far, we have identified cash flows, determined the length of the high growth period, and estimated both the growth rate and the cost of capital. However, a valuation professional must consider several additional aspects before finalizing the valuation. These aspects are crucial for ensuring a comprehensive and accurate firm valuation.

The following three aspects must be thoroughly deliberated:

1. Incorporation of Asset Values Not Included in the DCF Model: There may be valuable assets not accounted for in the traditional DCF valuation, such as non-operating or intangible assets like patents. For instance, a firm might own a piece of land not directly tied to its operating cash flows. The value of such an asset must be incorporated separately to ensure that the overall valuation reflects the total value of the firm’s holdings.
2. Measurement of the Impact of Equity Options: Equity options, such as employee stock options, can significantly impact a firm's valuation. These options represent potential claims on the company’s equity, which can dilute the value of existing shares. For example, if a company has 1,00,000 outstanding shares and issues 10,000 stock options to employees, the dilution effect must be factored into the valuation to determine the value per share accurately.
3. Estimation of the Value of Voting Rights: Firms may have different classes of shares with varying voting rights. For instance, some shares may carry enhanced voting power, allowing shareholders more influence over corporate decisions. The value of voting rights can be important in cases where control of the firm is an issue. Valuation professionals must estimate the value of these voting rights, as shares with more voting power may be worth more to certain investors than ordinary shares.

How should significant cash and marketable securities held by a firm be treated in the valuation of equity shares?

When a firm holds a significant amount of cash and marketable securities on its balance sheet, special consideration must be given to their impact on the valuation of equity shares. Treating income from these assets and adjusting the discount rate are crucial to ensure an accurate valuation.

1. Inclusion of Income from Marketable Securities: Income generated from holding marketable securities should be incorporated into the firm’s cash flows. This income represents an important component of the firm's financial performance and must be accounted for when forecasting future cash flows.
2. Adjustment of the Discount Rate: The discount rate used in the valuation should also be adjusted to reflect the lower risk associated with cash and marketable securities. These assets are less risky than the firm’s operating activities, reducing the firm’s overall risk profile. Consequently, the weighted average cost of capital (WACC) or discount rate must be adjusted downwards to account for the presence of these lower-risk assets.

What adjustment is required for the discount rate when cash flows from marketable securities are considered?

When cash flows from marketable securities are included in the valuation of a business, the firm's unlevered beta must be adjusted downwards to reflect the reduced risk associated with holding these liquid assets. Cash and marketable securities are highly fluid, entail minimal conversion costs, and carry lower risk than other operational assets. As a result, including these assets necessitates adjusting the discount rate to represent the firm’s risk profile accurately.

Unlevered Beta Adjustment: A firm's unlevered beta measures its assets' systematic risk, excluding the effects of debt. Since cash and marketable securities are the safest and most liquid assets, including them in the firm’s cash flows reduces the overall risk of the asset portfolio. Thus, the unleveled beta should be adjusted downwards, reducing the discount rate applied in the valuation.

Example: Suppose the original unlevered beta for a firm, based on its core operations, is 1.3. Given that a significant portion of the firm's assets is held in cash and marketable securities, which are low-risk, the unleveled beta might be adjusted to 1.1.

This adjustment reflects the lower risk associated with the firm's asset portfolio due to the presence of these highly liquid assets. Consequently, the adjusted discount rate (often derived using the Capital Asset Pricing Model, CAPM) would also be lower, reflecting the firm's reduced risk.

Adjustment in Discount Rate: For instance, if the original discount rate, calculated using CAPM, was:

Discount Rate = Risk-Free Rate + (Unlevered Beta × Market Risk Premium)

Assuming a risk-free rate of 5% and a market risk premium of 6%:

• Original Discount Rate = 5% + (1.3 × 6%) = 5% + 7.8% = 12.8%
• Adjusted Discount Rate = 5% + (1.1 × 6%) = 5% + 6.6% = 11.6%

In this example, the reduction in unleveled beta leads to a lower discount rate, accurately capturing the decreased risk due to the inclusion of cash and marketable securities.

In a nutshell, when cash flows from marketable securities are considered for business valuation, the unleveled beta should be adjusted downwards, leading to a reduced discount rate that reflects the lower overall risk of the firm due to the inclusion of these safe, liquid assets.

How should assets be incorporated into the value of a company when there are subsidiary companies with minority interests?

When a company has subsidiary companies and a minority interest in these subsidiaries, incorporating the value of these assets requires careful consideration. Simply including the income from the subsidiary companies can lead to an undervaluation, as it ignores a significant portion of the subsidiaries' total value.

An alternative approach is to perform a separate valuation of each subsidiary company and then compute the proportionate share attributable to the holding company. This proportionate value should then be included in the holding company's overall valuation to reflect the subsidiary's contribution more accurately.

Steps to Incorporate Subsidiary Value:

1. Valuation of Subsidiary Companies: Each subsidiary should be valued independently, using an appropriate valuation method such as Discounted Cash Flow (DCF) or Comparable Company Analysis (CCA). This step ensures that the full value of the subsidiary, including its tangible and intangible assets, is properly considered.
2. Proportionate Share Calculation: Once the total value of the subsidiary is determined, the proportionate share owned by the holding company should be calculated. This share reflects the ownership percentage held by the holding company. The minority interest—the portion not owned by the holding company—should be excluded from this calculation.
3. Inclusion in Holding Company Valuation: The proportionate value of the subsidiary (?40,00,00,000 in this example) should be included in the total value of the holding company. This ensures that the holding company’s valuation reflects the value of its ownership in the subsidiary, accounting for both income generation and asset ownership.

When dealing with subsidiary companies with minority interests, it is advisable to value each subsidiary separately, compute the proportionate share attributable to the holding company, and then include this share in the holding company’s valuation. This approach provides a more comprehensive and accurate reflection of the holding company’s value.

How should surplus balances such as pension funds be treated in valuation?

Certain funds, such as pension funds, are established to meet specific obligations. Occasionally, the balance in these funds may exceed their potential liabilities, creating a surplus. When considering such surpluses for valuation purposes, it is important to determine whether shareholders have the right to claim the excess amount after fulfilling the fund's obligations.

Suppose shareholders are entitled to claim the excess balance in the fund account over its liabilities. In that case, the after-tax portion of this surplus should be included in the company's valuation. This treatment ensures that the value available to shareholders is appropriately reflected in the overall valuation.

Example: Suppose a pension fund has a balance of ?10,00,00,000, and the associated liabilities amount to ?7,00,00,000. This results in a surplus of:

Surplus Balance = Fund Balance - Liabilities Surplus Balance

= ?10,00,00,000 - ?7,00,00,000 = ?3,00,00,000

If shareholders are entitled to this surplus, the after-tax value of the surplus must be calculated. Assuming a tax rate of 30%, the after-tax surplus would be:

After-Tax Surplus = Surplus Balance × (1 - Tax Rate)

After-Tax Surplus = ?3,00,00,000 × (1 - 0.30) = ?3,00,00,000 × 0.70 = ?2,10,00,000

This ?2,10,00,000 should be included in the company's valuation, representing the value shareholders can claim from the surplus fund balance.

In summary, if shareholders can claim the surplus in a fund, the after-tax portion of the surplus should be accounted for in the company’s valuation, ensuring that the potential value available to shareholders is accurately captured.

Conclusion

This edition highlighted key adjustments necessary for a thorough business valuation, including incorporating subsidiary values, surplus fund treatment, and risk adjustments for liquidity. Properly accounting for these elements ensures a more precise valuation, ultimately supporting better decision-making for investors, analysts, and valuation professionals.